Types of Investment decisions under risk.

1. Investment Decisions Under Risk

2. Investment Decisions and Risk
• The main function of a finance manager is to allocate various
resources among available investments
• Investment may be long term or short term
• Investment decisions are made on the basis of forecasts.
• Risk will also vary from one investment proposal to another
• Risk is defined as the variability that is likely to occur in
future between the estimated and actual returns

3. Types of Investment Decision
Situations
• Certainty : No risk involved
• Uncertainty : Future loss cannot be foreseen
• Risk : Future loss can be foreseen

4. Techniques of Investment Decisions
1) Risk Adjusted Discount Rate (RADR)
2) Certainty Equivalent method
3) Statistical Method
• Standard Deviation Method
• Coefficient of Variation Method
• Sensitivity Analysis
• Simulation Method
• Probability and expected values method
• Decision tree analysis

5. Risk Adjusted Discount Rate
• RADR is the discount rate which is used to convert future
cash inflow into present values.
• Investors expect a higher rate of return on risky projects as
compared to less risky projects.
Merits :
• It is easy to understand and very simple to calculate
• It gives some premium for risk
RADR = Risk free interest rate + Risk Premium

6. Demerits :
• It assumes that risk increases with time
• There is no proper method for calculate RADR – difficult to
calculate it
• Does not make use of information from probability distribution
expected future cash.

7. Certainty Equivalent Method
• It is a risk incorporation technique which adjusts the
expected cash flows, instead of adjusting discount rate.
• The estimated cash flows are reduced to certain amount
by applying a correction factor known as Certainty
Equivalent Coefficient
CE = Riskless Cash flows
Risky Cash flows

8. • CE Coefficient assumes a value between 0 and 1,and it
varies inversely with risk
Merits :
• It is simple to understand and easy to calculate
• It does not consider the risk increase with increase in time
Demerits :
• Difficult to consider increasing risk capacity
• Difficult and inconvenient to allocate CE Coefficients.

9. Standard Deviation Method
• It is used to compare the variability of possible cash flows of
different projects from their expected values.
• A project having high SD will be more risky
Coefficient of Variation
It is the risk per unit of return
CoV = Standard Deviation * 100
Mean

10. Sensitivity Analysis
• It is concerned with judging the sensitivity of items of
data which are needed to make a decision.
• It provides information about cash flows under three
assumptions :
1) Pessimistic
2) Most likely
3) Optimistic

11. Merits :
• It helps to know the viability of a project by considering
the variables
• It helps to frame alternative plans
Demerits :
• No clarity in results. Values may be inconsistent
• Fails to focus on the interrelationship between variables
• Ignores the chances associated with different values

12. Simulation Method
• It is also known as Method of statistical trails or Monte
Carlo’s Simulation.
• It involves random selection of an outcome for each
variable and combining these outcomes and obtaining one
trial outcome
• It is used to solve problems which cannot be represented
by mathematical models or by analytical method

13. Decision Tree Analysis
• Decision tree is a graphical representation of the
relationship between a present decision and future
events, future decisions, and their consequences in the
form of branches of a tree.
• Evaluation of a project can be done in different stages
and over a period of years with the help of decision
tree.

14. Merits :
• It is easy to understand and very simple
• Clearly brings out the assumptions and calculations
• Give an overview of all the possibilities – helps to keep the
entire picture in mind
• Helps to analyse the assumptions in graphical form
Demerits :
• Time consuming
• Complex
• Difficult to make calculations when tree diagram become more
complicated.